Volatility: what to expect over the next few weeks

Any avid reader of the headlines over the holidays may have assumed equity returns would have been affected by all the talk of trade wars, geopolitical squabbles and Brexit. But once again, the stock markets sailed on relatively serenely.

A mute point?

Barring the brief spike earlier in the year, volatility has been rather muted in developed markets, leaving them largely disconnected from all of the geopolitical tensions of recent times. As a result, valuations are still a little stretched but not sufficiently so in our view to trigger a bear market in general.

The real issue is whether you believe the economic upswing can be sustained. Recent manufacturing surveys results still point to robust growth in the US and stability in China. However, results in Germany and Japan seem to have peaked. Whatever your view on what these peaks signal, it could be worth preparing for some more volatility over the next few weeks.

What goes up...

So what does happen when survey results peak? Peaks are of course inevitable, but they don’t in themselves guarantee recession, far from it. In fact, we can identify more than 20 peaks in the ISM since 1960 but only six recessions (two or more consecutive quarters of negative growth). The current configuration of results suggest that while some economies are no longer accelerating - may even be decelerating – we are nowhere near recession.

Seasonally affected disorder

That said, we do expect more volatility post the summer. The charts below show the S&P 500 has tended to be more volatile in October than in any other month anyway since 1990.

By definition, few can predict the nature and timing of the market’s next outlier event. There are plenty of candidates including a full blown trade war, renewed concerns on China’s growth or the US entering an earlier-than-expected recession. Brexit negotiations will continue to dominate the front pages while the people will have their first say on the Trump presidency in the US mid-term elections on 6 November.

Get your sitting ducks in a row

Both the House of Congress and the Senate are up for grabs at the mid-terms and is likely the Democrats will retake at least one of them, particularly with the President’s popularity level bobbing around below the 40% mark. For all the wailing and gnashing of teeth over his policies and pronouncements, Trump has kept the equity bulls running, at least until now. But, as the chart below shows, US equities have tended to suffer larger-than-average losses ahead of almost every mid-term election since 1962. The maximum year-on-year decline of the S&P 500 during the June-October run-up to a mid-term is on average 16% - significantly higher than the 12% average during non-election years.

US market volatility vs. mid-term elections

Sources: Lyxor AM International, Bloomberg, data as at 04/09/2018

Past performances are not indicative of future results

Should the Democrats win both the House and the Senate, the risk of political gridlock between the administration and Congress becomes much more concrete. But we don’t foresee any major policy changes, whatever the outcome, so tax cuts remain the biggest near-term support for the economy. That said, any such uncertainty at such a late stage of the cycle could easily lead to more volatility.

Prepare for problems

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